Reading 49 LOS's

Question 1

LOS 49a: Explain the uses of industry analysis and the relation of industry analysis to company analysis

Answer 1

To understand a company’s business and business environment. This is used in fundamental analysis, stock selection, and valuation as it provides insight into a company’s growth opportunities, competitive dynamcics, business risk, and credit risk

To identify active equity investment opportunities. An analysis of industry fundamentals helps an analyst in forecasting the industry’s growth and profitability

To attribute portfolio performance Portfolio managers are evaluated on the relative performance of their sector and industry allocations. Industry classification plays an important role in perfromance attribution

Question 2

LOS 49b: Compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system

LOS 49c: Explain factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descriptors such as “growth”, “defensive”, and “cyclical”

Answer 2

There are three major approaches to industry classification

1) Products and/or Services Supplied

This classification scheme groups companies that make similar products and/or services. Companies are placed in industries based on their principal business activity. Industries that are related to each other are grouped together to form a sector.

2) Business-Cycle Sensitivities

A cyclical company is one whose performance is positively correlated with the performance of the overall economy. These companies typically have higher operating leverage, which may be accompanied by high financial risk.

A_non-cyclical_ company is one whose performance is relatively independent of the business cycle. Demand for their products remains relatively stable

Analysts also classify industries as defensive or growth industries. Defensive or stable industries are those whose profits are least affected by fluctuations in overal economic activity. Growth industries are industries whose specific demand dynamics override economic factors in determining their performance

Limitations of these classifications

• The classification of companies as cyclical or non cyclical is somewhat arbitrary. Economic downturns affect all companies
• At a given point in time different countries and regions may be undergoing different stages of the business cycle. Comparing companies in the same industry that are currently operating in very different economic conditions may help identify investment opportunities

Statistical Similarities

Statistical approaches group companies on the basis of correlations of historical returns. This approach has the following limitations:

• the comparison of industry groups may vary significantly over time and across geographical regions
• There is no guarantee that past correlations will continue to hold going forward
• A relationship may arise by chance
• A relationship that is actually economically significant may be excluded

Industry Classification systems

These help analysts in studying industry trends and valuing companies.

Commercial Industry Classification Systems

Major index providers around the world classify companies in their equity indices into industry groupings. They have multiple levels of classification and include:

• Global Industry Classification Standard (GICS), which classifies industries according to their principal business activity
• Russell Global Sectors (RGS), which classifies industries on the basis of goods and/or services produced
• Industry Classification Benchmark (ICB), which groups companies on the basis of primary revenue sources

Governmental Industry Classification Systems

Various government agencies organize statistical data according to the type of industrial or economic activity to facilitate comparisons over time and across countries that use the same system. They include:

• International Standard Industrial Classification of All Economic Activites (ISIC), which calssifies entities on the basis of their primary business activity. This is currently used by the UN, IMF, World Bank and other international bodies
• Statistical Classification of Economic Activities in the European Community (NACE) which uses a basis similar to that of ISIC
• Australian and New Zealand Standard Industrial Classification (ANZSIC)
• North American Industry Classification System (NAICS)

Strengths and Weakness of Current Systems

• Most government systems do not disclose information about specific businesses or companies, so an analyst does not have access to the constituents of a particular category
• Commercial classificatoin systems are reviewed and updated more frequently than government
• Government classification systems do not distinguish between small and large businesses, between for-profit, and not-for-profit, or between public and private companies. Commercial classification systems make distinctions between small and large companies automaticall by virtue of the companies’ association with a particular equity index

Question 3

LOS 49d: Explain the relation of “peer group” as used in equity valuation, to a company’s industry classification

Answer 3

A peer group is a group of companies engaged in similar business activities whose economics and valuation are influenced by closely related factors.

Commercial classification systems do provide a starting point in the construction of a peer group, as they provide a list of companies operating in the same industry. Analysts can then filter this list to come up with a set of companies whose businesses are truly comparable with that of the company being studied

Steps in Constructing a Preliminary list of peer companies

• Examine commercial classification systems to identify companies operating in the same industry
• Review the subject company’s annual report to identify any mention of competitors
• Review competitors’ annual reports to identify other potential comparable companies
• Review industry trade publications to identify comparable companies
• Confirm that comparable companies have primary business activities that are similar to those of the subject company
  *

Question 4

LOS 49e: describe elements that need to be covered in a thorough industry analysis

Answer 4

Investment managers and analysts examine an industry’s performance in relation to other industries to identify industries with superior returns. They also evaluate industries over time to determine how consistent and stable their returns are.

Elements taht need to be covered are macroeconomic, demographic, governmental, social, and technological factors that affect an industry at the macro level and how an industry is affected by competitive forces, life cycle issues, business-cycle considerations, and its position on the experience curve.

Question 5

LOS 49f: Describe the principles of strategiv analysis of an industry

Answer 5

Analysis of the industry with a view to examining the implications of the industrial environment on corporate strategy is known as strategic analysis. The starting point of strategic analysis is Porters Five Forces:

1. Threat of substitute products- If customers find products to substitute those produced by the company, demand for the company’s products will decline
2. Bargaining power of customers- This refers to the leverage enjoyed by customers in their dealings with the company
3. bargaining power of suppliers this refers to the leverage enjoyed by suppliers in their dealings with the company
4. Threat of new entrants- this depends on the strength of barriers to entry into an industry
5. Intensity of rivalry- This is dependent on the industry’s competitive structure

Note that the last 2 forces merit further investigation because almost all companies have competitors and must be wary of new entrants to their industries. When studying these forces, analysts should bear in mind that:

• Higher/stronger barriers to entry reduce competition
• greater concentration implies lower competition, while market fragmentation implies higher concentration
• Unused capacity in an industry, especially over an extended period, results in intense price competition
• Stable market shares for industry firms implies less concentration
• More mature industries tend to exhibit slower growth

Question 6

LOS 49G; Explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and return on capital

Answer 6

Barriers to Entry

• Low barriers to entry mean that new competitors can easily enter the industry which makes the industry highly competitive. Companies will have little pricing power
• High barriers to entry mean that existing companies are able to enjoy economic profits for a long period of time. They have great pricing power

However bear in mind that these dont always hold. High barrier companies can have little pricing power due to fierce competition and price wars.

Note that barriers to entry should not be confused with barriers to success.

Industry Concentration

• If an industry is relatively concentrated (few large firms dominate the industry) , there is relatively less price competiton. This is because:
  
  • It is relatively easy for a few firms to coordinate their activities
  • Lager firms have more to lose from destructive price behavior
• If an industry is relatively fragmented ( There is a large number of smalle firms in the industry), there is a relaitvely high price competition. This is becuase of:
  
  • firms are unable to monitor their competitor’s actions
  • Each firm only has a small share of the market, so a small market share gain can make a large difference to each firm

Industry Capacity

• Limited capacity gives companies more pricing power as demand exceeds supply
• Excess capacity results in weak pricing power as supply chases demand

Market Share Stability

• Stable market shares indicate less competitive industries
• Unstable market shares often indicate highly competitive industries with little pricing power

Market shares are affected by the following factors:

• Barriers to entry- the higher the barriers the more stable the market shares
• New products - More new products leads to less stable market share
• Product Differentiation those that are able to differentiate their product will experience increase in their share in the market

Question 7

LOS 49h: Describe product and industry life cycle models, classify an industry as to life cycle phase based on a description of it, and describe the limitations of the life-cycle concept in forecasting industry performance

Answer 7

The different stages in an industry’s life cycle are:

Embryonic Industries in this stage are just beginning to developed and characterized by:

• Slow groth as customers are still unfamiliar with the prduct
• High prices as volumes are too low to achieve significant economies of scale
• Significant initial investment
• High risk of failure

Companies will focus on raising product awareness and developing distribution channels during this stage

Growth- Once the new product starts gaining acceptance in the market, the industry experiences rapid grow. This stage is characterized by:

• New customers entering the market, which increases demand
• Improved profitability as sales grow rapidly
• Lower prices as economies of scale are achieved
• relatively low competition among companies in the industry as the overall market size is growing rapidly. Firms do not need to wrestle market share away from competitors to grow
• High threat of new competitors entering the market due to low barriers to entry

During this stage, companies focus on building customer loyalty and reinvest heavily in the business

Shakeout- The period of rapid growth is followed by a period of slower growth. Characterized by:

• Slower demand growth as fewer new customers are left to enter the industry
• Intense competition as growth becomes dependents on market share growth
• Excess industry capacity, which leads to price reductions and declining profitability

During this stage, companies focus on reducing their costs and building brand loyalty. Some firms may fail or merge with others

Mature eventually demand stops growing and the industry matures.:

• Little or no groth in demand as the market is completely saturated
• Companies move toward consolidation
• High barriers to entry in the form of brand loyalty and relatively efficient cost structures

During this stage, companies are likley to be pursuing replacement demand rather than new buyers and should focus on extending successful product lines rather than introducing revolutionary new products

Decline Technological substitution, social changes, or global competition may eventually cause an industry to decline.:

• Negative growth
• Excess capacity due to diminishing demand
• price competition due to excess capacity
• weaker firms leaving the industry

Limitations of Industry Life-Cycle Analysis

• The following factors may change the shape of an industry life cycle:
  
  • technological changes: An industry may go from growth to decline, if a new product trumps theirs
  • Regulatory changes
  • Social changes
  • Demographics
• Industry life-cycle analysis is most useful in analyzing industries during periods of relative stability. It is not useful in analyzing industries experiencing rapid change
• Not all companies in an industry display similar performance.

Price Competition

• Industries in which price is the most significant considerationg in customers’ purchase decisions tend to be highly competitive
• Price is not as important if companies in an industry are able to effectively differentiate their products in terms of quality and performance

Question 8

LOS 49i. Compare characteristics of representative industries from the various economic sectors

Answer 8

Example in book. Big chart

Question 9

LOS 49j: Describe demographic, governmental, social, and technological influences on industry growth, profitability, and risk

Answer 9

Macro Influences

An industry’s prospects are affected by overall economic activity. GDP, interest rates, availability of credit, and inflation all have an impact on the company’s revenues, costs, and profts

Tech Influences

Advancements in technology lead to new products being developed, which may replace older products. Further, these developments can sometimes change the way other industries use these products to conduct their operations

Demographic Influences

Demograph has important influence on economic growth and on the types of goods and services consumed. Example an aging population is negative to the workforce, but great for healthcare

Governmental Influences

Government regulations have an impact on all sectors of the economy. Governments might exert their influence on an industry directly through taxes or subsidies, or indirectly by establishing regulatory bodies to govern the actions of an industry

Social Influences

These influences refer to changes in how people work, spend their money, enjoy their leisure time, and conduct other aspects of thir lives

Question 10

LOS 49k: describe the elements that should be covered in a thorough company analysis

Answer 10

Company analysis includes an analysis of the company’s financial postion, products and/or services, and competitive strategy. Porter identified 2 main competitive strategies:
Cost Leadership

Companies pursuing this strategy strive to cut down their costs to become the lowest cost producers in an industry so that they can gain market share by charging lower prices. Pricing may be defensive or aggresive

Product/Service Differentiation

Companies pursuing this strategy strive to differentiate their products from those of competitors in terms of quality, type, or means of distribution. These companies are then able to charge a premium price for their product.

Elements that should be considered in a Company Analysis

• Provide an overview of the company
• Explain relevant industry characteristics
• Analyze the demand for the company’s products and services
• Analyze the supply of products and services including an analysis of costs
• Explain the company’s pricing environment
• Present and interpret relevant financial ratios, including comparisons over time and comparisons with competitors